Thank You

Error.

Emerging-markets investors entered the year with high hopes for Brazil. They should give those hopes a rest. Brazil is set to disappoint once again.

The MSCI Brazil Index gained 10.1% last year, trailing the MSCI Emerging Markets Index by 7.25 percentage points. But things were looking up headed into 2013. Economic growth—which came in at about 1% last year—was expected to pick up, as the 3.75 percentage points of central-bank rate cuts made their way though the economy. Recent underperformance also meant that value seekers would be sending money Brazil's way, betting on a bounce.

But Brazil's economy has proved to be far messier than many thought it would. Heavy-handed intervention in private industry has caused companies to put off new projects, which means that the rate cuts may not have the expected impact -- and economists have already started dialing back their growth forecasts for 2013. More troublesome, the annual inflation rate rose to 6% in mid-January, Brazil reported on Jan. 23, far hotter than anyone -- including Brazil's central bank -- is comfortable with.

As a result, Brazil's stocks are underperforming emerging markets once again: the MSCI Brazil has lost 1.1% this year, while emerging markets have gained 1.4%, in local-currency terms.

Inflation is a big part of the problem. Despite a slowing economy, prices jumped to 5.8% in December, from 4.9% in June 2012, according to FactSet. And academic research has shown that rising prices haven't been good for Brazil's stock market. If investors start expecting a higher inflation rate, Brazil's stock market could take a hit.

Brazil's inflation problem would appear to benefit the stocks of commodity producers and other so-called cyclicals tied to the strength of the global economy. Ordinarily, they should get a boost now that China is showing signs of strength. There's only one problem: Those stocks are the ones that could be most affected by government intervention, says Michael Hood, institutional strategist at J.P. Morgan Asset Management. In Brazil, "The worry is that the tail wind [of global growth] would specifically collide with government activism," he says.

SO WHAT KIND OF STOCKS should investors look at? Edward Kuczma, an investment analyst at Van Eck Global who specializes in Latin America, says Brazil's education stocks could be immune to many of the problems facing the country right now. Because of Brazil's tight labor market, going back to school can provide a nice bump in pay, and education is also likely to be a focus of the next election in 2014. "A lot is working in favor of education in Brazil," he says.

Another option: Choose a top-performing mutual fund with a smaller-than-benchmark weight in Brazil, such as
Thornburg Developing World
(THDAX) and
Calamos Evolving World Growth
(CNWRX), which have about 10% of their portfolios in Brazilian stocks -- less than the iShares MSCI Emerging Markets Index ETF's (EEM) 13%. And then wait for next year.